A tradable security is commonly defined as a document which provides written evidence of ownership or creditorship. The most common form of tradable security is a share of stock. A share of stock represents an ownership interest in a business. The value of a share of stock rises and falls over time depending on both the success or lack thereof of the underlying business and a variety of market forces.
Other well-known tradable securities are shares in an exchange traded fund, a debt obligation, or a commodity. The common characteristics among these tradable securities is that they are made available to investors for either purchase or sale.
A derivative of a share of stock is an option contract. Option contracts are another form of tradable security. The origin of the option contract can be found in the markets for trading commodities; particularly, agricultural commodities. Specifically, to provide some predictability for the farmers who raised crops to be sold in the future on the open market, the concept of an option contract came into being as a method of reducing risk for the farmers. Thus, by the use of option contracts farmers could count on the expectation of receiving a predetermined price for a predetermined quantity of a crop at a predetermined time in the future.
The present invention also involves the use of option contracts. The option contracts used in the present invention relate to the underlying tradable security. Not all tradable securities have associated option contracts. An option contract is a promise to either buy or to sell a defined quantity of an underlying tradable security at predetermined price at a predetermined future time. The contractual promise either to buy or to sell the defined quantity of an underlying tradable security at a predetermined price, called the strike price, by a predetermined time has its own value separate and apart from the inherent value of the underlying tradable security. Such option contracts are traded at prices which rise and fall over time in option contract markets where purchasers may buy and sellers may sell option contracts.
Those knowledgeable in option contracts understand that there are two types of option contracts: a call option contract and a put option contract. In a call option contract, the offeror of the call option contract receives money for his promise to be called out by the owner of call option contract to sell to the owner of the call option contract a tradable security at a predetermined date sometime in the future. For example, if a stock is trading at $15 in June, a seller of a call option contract will receive money for selling his call option contract which represents the seller's promise to sell to the buyer of the call option contract the underlying stock for a $20 strike price at a predetermined date in July. The buyer of the call option contract believes that the value of the stock will go to $30 in July; therefore, having the right to buy the stock at $20 or $10 less than the market price before a predetermined date in July will be valuable. Thus, the buyer of the call option contract believes that it is worth the cost of the call option contract to lock in a future purchase price for a tradable security.
If the price of a share of the stock on the open market increases, the owner of the call option contract will effectively call the seller of the call option contract with a demand or a call out of the seller of the call option contract to purchase the predetermined number of shares of stock (typically 100 shares) at the agreed upon strike price in the call option contract before the call option contract expires. If however, the agreed upon strike price for the purchase of the stock by the buyer of the call option contract is lower than the stock is presently trading, then the call option contract has no value. If the value of the underlying stock never increases beyond the strike price, then the call option contract will eventually expire worthless and the seller of the call option contract keeps the money paid to the seller of the call option contract by the buyer of the call option contract.
A put option contract is typically used when the buyer of a put option contract believes that the price of the underlying tradable security may decrease. Thus, the buyer of a put option contract has spent money to purchase the right to put a contractual obligation to the seller of tradable security to sell a predetermined number of stock shares of the underlying security at the strike price of the put option contract so that the underlying security will be purchased by the seller of a put option contract at a predetermined strike price even if the price of the tradable security falls below the strike price in the put option contract.
If the price of the underlying security increases instead of decreases there is no reason to put the put option contract to one agreeing to buy the underlying security at a predetermined strike price as a better price can be obtained for the underlying security by selling the underlying tradable security on the open market. Accordingly, if the price of the underlying security goes up the put option contract will eventually expire worthless.
Some owners of tradable securities see a put option contract as a form of insurance. That is, if the owner of a tradable security has purchased the right to put the tradable security to a buyer who is contractually obligated to buy the underlying tradable security at a predetermined strike price according to the put option contract, the owner of the put option contract has a price floor beneath which the worth of the underlying tradable security to the owner of the tradable security will not fall.
The basic purpose for purchasing and selling tradable securities is to exchange cash today for something that will have a greater value in the future. At some future time, it is anticipated that selling the tradable security at a higher price will produce more cash than what was originally paid. Thus, if one buys a tradable security at a particular price, one hopes to sell that tradable security at a higher price sometime later in time. If one sells and receives cash for selling an option contract, one hopes that the option contract will either expire worthless or that it will be possible to either buy back the option contract at a lower price in the future and pocket the difference in price.
The difference between the purchase price of a tradable security and a higher sale price later in time is profit. The difference between the purchase price of a tradable security and a lower sale price later in time is a loss. Some tradable securities go up substantially in price and produce large amounts of profit for their owners. Others do not. The difference between either the profit or loss over time in the value of a tradable security is attributed to the risk associated with the tradable security. High risk tradable securities have the potential of producing large profits over time; but high risk tradable securities also have the potential of producing large losses over time. Tradable securities are selected by purchasers based on the perceived risk associated with the probabilities that the future price of the tradable security which reach a level higher than what was paid for the tradable security.
For those interested in making money in the purchase and sale of tradable securities, there remains a continuing search for tradable securities, option contracts on tradable securities, or a combination of tradable securities and option contracts on tradable securities which minimize both risk, and maximize profit potential.